Pension – Page 3 – Doug Carroll

Why RRSP room lags a year behind money purchase pension limits

Why RRSP room lags a year behind money purchase pension limits: Reconciling retirement savings using the pension adjustment

To many, the tax system may seem to work in mysterious ways, sometimes to the point of appearing unfair. In truth though, fairness is a key principle informing our system, tempered with the real-world practicality of putting that principle into operation.

A visual way to show the contrast in terms of retirement savings would be to look at two savers, one who is a member of a money purchase registered pension plan (MP RPP), and the other making use of registered retirement savings plan (RRSP) room. On the face of it, this gives the impression of a systemic one-year lag in available contribution room that favours pensions over individual savings. (See table.)

But is this reality or illusion? An explanation of the pension adjustment (PA) will shed some light on the matter.

The pension adjustment

Our retirement savings system is designed to provide the opportunity for savers to set aside as much as 18% of annually earned income into one or more tax-sheltered plans: RRSPs, RPPs (whether MP or defined benefit(DB)), and deferred profit sharing plans (DPSPs).

To gather together the components of the comprehensive 18% limit, a pension credit system operates:

Straight dollar-for-dollar pension credit for contributions to MP RPPs and DPSPs,
A dollar-equivalent credit for benefits accrued under a DB RPP, based on the particular plan’s provisions

When accumulated, the total pension credits for a year form the PA, which is applied to reduce the maximum RRSP contribution room for the following year. Of course RRSP room for a current year is based on earned income in the prior year. Thus the PA dovetails the available information from the prior year into the current year’s RRSP room calculation.

Note that there is no pension credit calculation for contributions to group RRSPs, as this latter plan type simply shares the maximum RRSP room after the PA calculation.

… and PSPA, and PAR

The story doesn’t end with the PA alone. There are two other components to the system that account for changes in RPP and/or DPSP plan benefits, and may affect RRSP room.

There may be changes to a DB RPP that improve the pension the member would be entitled to receive. For example, there could be a negotiated increase to the per-year credit rate in calculating the eventual pension, say from 1% to 1.5%. In light of the improved benefit, the pension member had been entitled to place more in RRSPs than should have been the case. A past service pension adjustment (PSPA) sums up the pension credits that would have applied based on the upgraded benefits, and this then reduces RRSP room.

Just as the PSPA may reduce RRSP room, when someone terminates membership in a DB RPP or DPSP, there may be a loss of expected benefits. A pension adjustment reversal (PAR) restores RRSP room that had been previously reduced based on that expected but now un-received benefit.

The full RRSP room calculation

Gathered together, the RRSP contribution limit for a year is:

+ Unused room at the end of the immediately preceding year

+ 18% of previous year’s earned income (subject to RRSP dollar limit

– Any PA

– Any PSPA

+ Any PAR

TABLE: Contribution limits since 2003

RRSP MP RPP DB RPP DPSP

2003 $14,500 $15,500 $1,722.22 $7,750

2004 $15,500 $16,500 $1,833.33 $8,250

2005 $16,500 $18,000 $2,000.00 $9,000

2006 $18,000 $19,000 $2,111.11 $9,500

2007 $19,000 $20,000 $2,222.22 $10,000

2008 $20,000 $21,000 $2,333.33 $10,500

2009 $21,000 $22,000 $2,444.44 $11,000

2010 $22,000 $22,450 $2,494.44 $11,225

2011 $22,450 $22,970 $2,552.22 $11,485

2012 $22,970 $23,820 $2,646.67 $11,910

2013 $23,820 $24,270 $2,696.67 $12,135

2014 $24,270 $24,930 $2,770.00 $12,465

2015 $24,930 1/9 MP 1/2 MP

MP RPP = Money purchase registered pension plan (also know as a defined contribution registered pension plan),
DB RPP = defined benefit registered pension plan,
DPSP = deferred profit sharing plan

Commuting a defined benefit pension plan: Calculations and considerations

Leaving employment can be an emotional event, whether initiated by the employee, forced by the employer or undertaken in concert; for example, under an early retirement program. Obviously, it is also a significant financial event, with both current effects and life-long implications.

Where a defined contribution (DC) or defined benefit (DB) registered pension plan is in place, the departing employee will commonly have the option to continue in the plan, or to transfer to a new employer’s plan or a locked-in retirement account.

In the case of a DC plan, this is fairly straightforward. On the other hand, the commuted value of a DB plan has to be determined by calculation, and can be particularly high in a low-interest-rate environment. While this clearly has its appeal, the procedure and tax implications are more complex. Ultimately, an informed decision should be tailored to fit the individual’s current needs and future expectations.

Commuted value of the pension

Under a DC plan (also known as a money purchase plan), the known element is the amount of the employer’s contribution obligation. These contributions grow tax-sheltered, with the amount of the pension based on accumulated value at the retirement date. If an employee departs prior to retirement, the plan may be transferred dollar-for-dollar into a locked-in retirement account.

By contrast, the employer’s obligation under a DB plan is to provide a calculated pension amount, irrespective of the contributions required to get there. An actuary is involved at the outset and on an ongoing basis in calculating the employer’s funding obligation, which will be adjusted from time to time according to past investment performance, future economic expectations, and the number and characteristics of plan members.

If an employee departs a DB plan prior to retirement, it will be necessary to obtain an actuarial report to determine the value of that person’s entitlement in the accumulating pension fund. The formula is deceptively simple:

[annual pension] x [present value (PV) factor]

The annual pension is the expected amount that would be due at the normal retirement date. That’s the easy part. On the other hand, the PV factor depends on a myriad of inputs, including:

Age at calculation date
Gender
Assumed commencement date
Any applicable reduction factor for early commencement
Continuation provisions (e.g., to spouse) and any guarantee periods
Indexation, if any
Adjustments that may be required by the jurisdiction’s pension legislation

The ‘how’ of combining these inputs is governed by the Actuarial Standards Board in section 3500 of its Standards of Practice for Pension Plans. Be forewarned if you plan to look this up; it is not for those who are faint of heart when it comes to arithmetic.

Maximum tax-free transfer

The commuted value from the actuary’s report should not be confused with the amount that can be transferred into a locked-in retirement account. The commuted value is essentially a property right between an employer and an employee, whereas the transfer amount is a fiscal issue between Canada Revenue Agency and a taxpayer.

The relevant rules are in Income Tax Act (Canada) section 147.3(4) and Income Tax Regulation 8517. In a similar manner to how the commuted pension value is derived above, the maximum amount that is transferable to a locked-in registered account is prescribed under the regulation as:

[lifetime retirement benefits] x [PV factor]

There are a number of factors affecting the lifetime retirement benefits figure, but at the core it is the annual pension the retiree would otherwise have been entitled to eventually receive.

The present value factor is laid out in a table in the regulation according to the person’s calendar-year age. It is 9.0 below age 50, rises to a peak of 12.4 at age 65, then declines to 3.0 for age 96 and over.

This PV factor is narrower than the commuted-value PV factor outlined above. For example, it doesn’t account for any indexing or early retirement benefits. As a result, the tax transfer value is often less than the commuted pension value. The difference or excess amount will be taxable in the current year, though the impact of this may be reduced if the person has RRSP contribution room and chooses to make a corresponding contribution.

Decision considerations

Apart from the value of the commuted plan and tax transfer, here are some surrounding issues to review before committing to a course of action:

Investment of the commuted value may ultimately deliver a larger retirement income, but this should be balanced against downside investment risk
Is the person comfortable leaving behind indexing and guarantees that may have been part of the original pension?
Does the person wish to adjust income from year to year or ever make a lump-sum withdrawal? Subject to provincial limits, this will generally be possible only if the pension is commuted
Some pension plans allow continued health and dental coverage. In contrast, a person in poor health may prefer to take the commuted pension due to a shorter life expectancy
Spousal pension income splitting is available under age 65 from of a registered pension plan, but generally only on or after age 65 for an individual life income fund
Beyond a spouse, a person may wish to leave a legacy to family or charity. Managing a commuted pension amount may be the easiest way to facilitate such a plan

Revoking a spouse beneficiary on separation

At issue

The breakdown of a marriage is seldom a pleasant or simple process to work through. One potentially problematic aspect of this is how to deal with the revocation of life insurance and RRSP/RRIF/pension beneficiary designations. Despite expressed intentions and commitments in a separation agreement, additional positive steps may be necessary to give effect to a purported change.

Here is a recent trial court decision where an ex-spouse remained on record as life insurance beneficiary, and a couple of appeal court decisions that provide further context.

Love v. Love, 2011 SKQB 176

The separation agreement made reference to the husband’s pension, but made no mention of the group life insurance on which the wife was the named beneficiary. Following separation, the husband sent an email to his employer’s human resource department requesting the necessary paper work “to change the beneficiary on my pension etc. (from my former wife to my son).” After his death, the incomplete form was found in his files.

The court held that an email could suffice as a “declaration” to change a beneficiary under the Saskatchewan Insurance Act. On the facts however, neither the reference to the policy (“etc.”) nor the new beneficiary were sufficiently clear, particularly as there were actually three sons.

Richardson Estate v. Mew, 2009 ONCA 403

The Ontario Court of Appeal provides a useful summary of cases involving the interaction of separation agreements and beneficiary designations, and enunciates some principles for analyzing the cases:

“A former spouse is entitled to proceeds of a life insurance policy if his or her designation as beneficiary has not changed. This result follows even where there is a separation agreement in which the parties exchange mutual releases and renounce all rights and claims in the other’s estate. General expressions of the sort contained in releases do not deprive a beneficiary of rights under an insurance policy because loss of status as a beneficiary is accomplished only by compliance with the legislation. The general language used in waivers and releases does not amount to a declaration within the meaning of the Insurance Act.”

Martindale Estate v. Martindale, 1998 CanLII 4561 (BCCA)

The British Columbia Court of Appeal held that, on the facts in evidence, it would be a breach of the separation agreement for the ex-husband to claim insurance proceeds from the death of his ex-wife. Instead, he received the proceeds only as trustee of a constructive trust for the benefit of the intended beneficiaries.

In the words of the Court, “it would be against good conscience for the appellants to keep this money because Mr. Martindale had, by the separation agreement, surrendered any right he might have had to the property of the deceased.”

Practice points

Separating spouses and their lawyers should be sure to direct their minds and their drafting to explicitly address life insurance and RRSP/RRIF/pension beneficiaries in the separation agreement.
The Martindale result should be viewed as the exception to the general approach expressed in the Richardson case. To achieve greater certainty, separated spouses should change beneficiaries using each respective institution’s forms and procedures.